The People’s Bank of China is magnificently right

After Franklin Roosevelt devalued the dollar against gold in the midst of a global deflationary spiral, the economist John Maynard Keynes declared in the Daily Mail, “President Roosevelt is Magnificently Right.” So is the People’s Bank of China. The soaring US dollar rose 25% on a trade-weighted basis between June 2014 and March 2015, for two reasons: The US Federal Reserve declared its intention to raise interest rates while the economy weakened, and China’s central bank allowed the RMB to rise in lockstep with the dollar. After the RMB devaluation, the trade-weighted US dollar index DXY fell from a high of 98.3 on August 5 to 96.2 as of 10:00 a.m. EST Wednesday. Gold has risen from $1,085 to $1,117. Oil is down slightly, but that’s probably more supply-related than currency-driven. Inflation expectations as registered by the bond market (“breakeven inflation”) are unchanged at the 5-year level. What’s bad about that? The flight to safety in equity and bond markets seems wrong-headed.

We would have preferred, to be sure, a clear statement from the PBoC announcing a general adjustment of monetary policy, including a reduction of interest rates. With China’s PPI at -5.4% YOY and CPI at +1.6%, most Chinese businesses and consumers are paying much higher real rates than their Western or Japanese counterparts. The PBoC’s penchant for doing things piecemeal appears to have confused the market. That doesn’t change the fact that it did the right thing.

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Deflation, by definition, is an increase in the value of a currency against goods (and, relatively speaking, other currencies). During the year to date, the rise and fall in the oil price has tracked (inversely) the rise and fall of the trade-weighted dollar.

The press is full of reports that China’s RMB devaluation is a sign of economic slowing. On the contrary: the fact that the People’s Bank of China allowed the RMB to float upward with the dollar for the past year and a half is a major cause of China’s manufacturing slowdown (it’s hard to say taht the overall Chinese economy is slowing when the revenue’s of the country’s largest retailer, Alibaba, are up 34% year on year). A number of analysts, including the former chief China economist at the Bank for International Settlements, Dr. Guonan Ma, have been urging PBoC to abandon the dollar peg for quite some time. Dr. Ma wrote last February in the Financial Times:

This 20-year old dollar peg has served the Chinese economy well, but its time is up. First, as the biggest trading nation and second largest economy, China is too big to be anchored to any single currency, even in a loose fashion. Second, a dollar peg has often amplified external shocks to the Chinese economy, because of the dollar’s safe haven role. Finally, the US no longer welcomes a renewed Chinese peg to its currency and yet demands nothing but ‘one-direction flexibility’.

It’s high time that the PBoC lets the dollar peg go.

Reorient Group head of China research Steve Wang wrote in a note to clients Aug; 11:

To give a real boost to Chinese exporters, the USD/CNY needs to re-rack to 6.6, representing a 7% decline from the currency’s unproductive “SDR-peg” to the dollar at 6.2 during the past four-and-half months. That would directly help to offset the 7.3% contraction in Chinese foreign trade recorded for the first seven months of 2015, in which imports slumped by nearly 15% while exports fell 1% from comparable periods in 2014. Unbuckling the yuan’s unilateral adherence to the strong dollar would also lend more breathing room to China’s struggling wider non-financial economy, which has been threatening to decelerate below 6% real growth despite the Chinese government’s recurring easing moves.

The Chinese central bank’s decision to give interbank market makers more say in setting the renminbi’s daily midpoint reference rate vs. the US dollar is aimed at repairing PBOC credibility which was tarnished by the prolonged divergence of official fixings and the currency’s actual trading level, or “market expectations” as the central bank acknowledged in the accompanying press release posted on its website. The USD/CNY has been trading at or near the weak side of its daily allowed band since December as the PBOC tried to keep the yuan stable, but way stronger than what the market believes it should be given skittish economic reality.

Tuesday’s “one-off” correction for the reference rate has more to go as the spot currency pair has continued to trade on the weaker end, well above 6.3 for much of Tuesday given the 6.2298 fixing, meaning the 6.6 target is closer than one might imagine. The central bank notice said, starting Aug.11 that the daily midrate will be set “according to the previous market close price, while taking into account the foreign exchange supply and demand situation, as well as fluctuations of major international currency exchange rates.”

China’s move is a signal to the Fed that monetary tightening is a bad idea in a very weak economy. What’s broke in the US economy is investment and risk-taking, and monetary policy can’t fix that. If the Fed gets the message and puts off an adjustment in interest rates until the US economy gets out of its rut, markets should rally.